Mongolian Mining Corporation (SEHK:975) - Strategic Value Creation

Summary

A Proposal for a Cryptocurrency Mining Business Transformation to Create Mongolian Crypto Mining Corporation.

Odjargal Jambaljamts and Members of the Board of Directors

Mongolian Mining Corporation

16th floor, Central Tower

Sukhbaatar District

Ulaanbaatar 14200

Mongolia

Dear Odjargal Jambaljamts and Members of the Board of Directors:

We represent a group of investors that hold a position in the shares of Mongolian Mining Corporation (SEHK: 975) – referred to henceforth as ‘MMC’. We initiated our position in January 2017 and have closely followed the developments of the company since that time. During this period, an investment in MMC’s commons stock would have returned (42%), underperforming the Mongolia Stock Exchange Top 20 Index which returned nearly 70% over the same time period. Additionally, due to both poor execution by MMC’s management team as well as developments outside the management team’s control, MMC was unable to take advantage to one of the most significant increases in the price of metallurgical (also known as coking) coal in the past few years. As a result, MMC also greatly underperformed peers that were engaged in similar coking coal exploration / production activities over the course of the past year.

We believe that MMC’s management team has taken insufficient steps to diversify the company’s business in light of the negative political / economic developments that have taken place over the course of 2017 that have led to such poor business (and correspondingly poor share price) performance. While we remain supportive of MMC’s efforts as part of the Consortium including both China Shenua Corporation (“China Shenua”) and Sumitomo Corporation (“Sumitomo”) in regards to the mining rights of the West and East Tsankhi coalfield of the Tavan Tolgoi Project (“TT Mining Project”), we believe MMC can take significant steps in the interim to diversify into attractive new business opportunities that will produce strong returns for shareholders.

The crux of our proposal is for MMC to take advantage of recent actions initiated by Chinese regulatory authorities to curtail cryptocurrency activity within Chinese borders by diversifying into various lines of cryptocurrency business, but principally focusing on cryptocurrency mining. We discuss our proposal in depth below, but believe that Mongolia represents a geography highly conducive to the business of mining cryptocurrencies. Additionally, we believe that Mongolia’s historical economic / financial volatility which has in turn led to the instability and distrust of the Mongolian tögrög (MNT) creates an environment highly conducive to the general adoption of cryptocurrency assets as both functional currencies and stores of value.

We hope you consider our proposal and consider the shareholder value creating measures we outline.

Background of MMC and Situation Update

While we are sure the Members of the Board are familiar with the trials and tribulations of MMC, we feel that outlining the history and reasons for share underperformance would be educational for both the public shareholders of MMC and the general investing public. Note that throughout this section we lift our commentary many times directly from the Joint Provisional Liquidators (“JPL”) report available via MMC’s Investor Relations website.

Economic disruption following the election of the Democratic Party (DP) in 2012 led to a rapid contracting of GDP and a government deficit that represented a substantial portion of Mongolia’s GDP. On December 1 2014, MMC in conjunction with China Shenua and Sumitomo formed a Consortium to bid for the TT Mining Project. The government of Mongolia’s intent was to give up its current mining operations, effectively privatizing the operation of the Tavan Tolgoi mine. The Consortium was to finance a power plant and operate the mine, and more importantly, was required to finance the construction of a railroad (“Railway Project” that would enable the transport of Mongolian coal. While one of the lowest in terms of cost to extract, the lack of an effective transportation mechanism makes Mongolian coal more expensive than comparable Australian coal. Currently, coal must be transported by trucks from the mining area to Tsagaan Khad (“TKH”), a town approximately 30km from the Mongolian-Chinese border. The coal is subsequently transported from TKH to Gantsmod, the Mongolian-Chinese border city through contracted third-party Chinese trucking services.

The Railway Project is expected to reduce logistic costs for coal transportation within the Mongolian territory and also allow access the coal market along the Chinese steel belt. The Railway Project when constructed will link to the existing railway owned by China Shenhua within the Chinese territory, such that outputs from the TT Mining Project and the existing UHG mine may be transported directly to the Chinese steel belt in the Bohai Rim area via rail. With the railroad, the Consortium would be able to ramp production and ship significantly more coal than was previously possible.

The Government of Mongolia (“GoM”) would receive royalties and taxes on the coal, which would strengthen its finances and improve Mongolia’s economy. The Chinese would receive a 49% economic interest in the TT (51% to be kept by MMC as it is a Mongolian affiliated company) as well as a geopolitically secure source of coal. It was thought to be a deal that greatly benefitted all parties.

Due to suspected affiliations of MMC with the opposition political party, the Mongolian People’s Party (MPP), it was suspected that the DP controlled government axed the deal. The economy continued to deteriorate.

During this time period, the state-owned producer Erdenes Tavan Tolgoi (“ETT”) sold coal at vastly uneconomic prices. MMC had no choice but to idle its equipment in response to undercutting by its state-owned rival. This led to financial distress and MMC was forced to under go a financial restructuring that led to its various debt holders accepting a combination of modifications, including a haircut on their debt and swapping their old debt for new financial instruments such as Paid-in-Kind debt as well as equity in MMC.

In response to the economic decline, Mongolia (one of Asia’s few examples of a robust democracy) voted in the June 2016 elections overwhelmingly to place the MPP into power.

The central bank of Mongolia has been running down its foreign reserves in recent years. On 18 August 2016 it raised the benchmark interest rate to 15% in order to protect the currency. The timely commencement of the TT Mining Project and the Railway Project is therefore considered to be important for economic stability. Recognizing that the Consortium was back on the table with the MPP in power, shares of MMC began to rally upwards in Fall of 2016.

A series of unfortunate economic / political developments throughout the course of late 2016 and 2017 delayed the finalization of the consortium project.

A visit by the Dalai Lama in late 2016 sponsored by the Mongolian government infuriated Chinese authorities and led them to threaten scrapping the entire deal (China Shenua is a Chinese State-Owned Enterprise, or SoE). This led to a time period of back channeling between the Mongolian and Chinese governments to essentially repair what the Chinese saw as a mangled relationship.

In mid-February 2017, the International Monetary Fund (“IMF”) agreed to provide Mongolia with a bailout in regards to upcoming debt obligations. This was done in conjunction with the Chinese opting to roll over its swap line with Mongolia in regards to Mongolia’s trade deficit. This provided Mongolia with temporary economic relief it needed badly and helped stabilize the MNT.

In an astoundingly poorly calculated political move that is reminiscent of David Cameron’s decision to call for a referendum on Brexit or Theresa May’s decision to call snap elections later in 2017, the MPP decided it wanted to solidify its political position and opted to delay the decision to finalize the TT Mining Project and Consortium until after the 2017 Mongolian Presidential Election (distinct from the legislative elections in the Summer of 2016 that swept the MPP into legislative power).

The Mongolian people, a fickle lot, opted to swing back to the DP – seemingly unsatisfied with the measures pursued by the MPP to stabilize the economy. The initial election went to a runoff between the DP candidate (Khaltmaa Battulga) and the MP candidate (former parliamentary speaker Miyeegombo Enkhbold). Battulga soundly trounced Enkhbold in the runoff, and Mongolia was left with a divided government with the Presidency held by the DP and the Parliament held by the MPP. Even if the Consortium were to be forced through by the MPP parliament, the process would be much less smooth than had it been finalized prior to the Presidential elections. To date, the Consortium has largely advanced nowhere.

During this same time, supply disruptions from China curtailing its own coking coal output for environmental reasons as well as disruptions in Australia arising from Cyclone Debbie resulting in coking coal (used in the production of steel) prices rallying to levels not seen in years. MMC was able to exploit this to some degree in the first half of 2017 and reported a small profit for the first half in 2017 (excluding the profit artificially record due to accounting adjustments as a result of the debt restructuring) – MMC’s first profit in years.

Unfortunately, the Chinese government continues to view the TT Mining Project as strategically important to them from a geopolitical perspective. Xi Jingping was reported as saying “"Cooperating on comprehensive development of mining projects such as Tavantolgoi and construction of railways, power stations, copper concentrator plant based on Oyu Tolgoi mine will be consistent with national development strategies of two countries" by the Mongolian press. Understanding that the Mongolian economy was dependent on coal exports to China, in Fall 2017 the Chinese moved to force a border closure, limiting coal exports to a quota for various Mongolian coal producers. While we are unable to verify, rumors suggest that the Chinese are either moving towards a complete border closure before the end of January or have already done so. The result is economic pain and deterioration in Mongolia’s economic position.

The quotas have severely limited MMC’s ability to export coal and conduct the operations required to pay down the working capital liabilities it has built up a result of its mining operations. In fairness, we give the management team credit where credit is due. They have done a tremendous job navigating operational curveball after curveball. The latest operational data (as of January 15, 2018) indicates that more HCC coal was sold in the fourth quarter of 2018 than the fourth quarter of 2017; if such sales translated to cash receipts accretion to the equity would be significant. If the current political situation were more stable and MMC had an unfettered ability to export, we believe the equity could double from current levels provided metallurgical coking coal prices stay stable. This is without a consortium approval. As such, we have not sold any of our position. However, we believe the volatility of the political situation makes a scenario where MMC is able to conduct ‘business as usual’ highly unlikely.

If the Consortium agreement is not magically finalized prior the Tsagaan Sar holiday at the end of February 2018, it is unlikely that any agreement will be finalized as the next round of parliamentary elections occurs in Summer 2018. Knowing the Mongolian people and the economic pain brought from the export quotas, we expect the DP to be brought into power. If so, MMC could be back in the penalty box politically. We think it possible MMC is left to its own devices to mine and export its current coal under a DP controlled Presidency and Parliament, but we would rather not take our chances. Our desire to create ‘option value’ for the equity has led us to propose the following plan for MMC’s diversification.

We strongly believe that MMC should make a strong and concerted effort into cryptocurrency related business activities, specifically cryptocurrency mining.

We believe Mongolia is extremely well positioned to capture the role as the world’s top cryptocurrency mining country. As reported recently by the Financial Times on January 9, 2018, a multi-agency Chinese government task force has instructed provincial Chinese governments to actively guide companies engaged in cryptocurrency mining in their respective jurisdictions to exit said businesses. The move comes shortly after China’s shut down of local cryptocurrency exchanges and its ban on initial coin offerings (“ICOs”). The Chinese have a history of pushing activities (such as coal mining – see the recent capacity reductions at Chinese coal mines) beyond their borders to other nations. This enables the Chinese to observe on such activities, but not endorse such activities within their borders. We feel that such a philosophy makes Mongolia a prime candidate for cryptocurrency mining; a nation where the Chinese could observe the trajectory and development of such activities without being concerned about the political ramifications of it taking place within their own borders.

China mines nearly three quarters of the world’s bitcoins. They have been able to do so precisely because of cheap electricity in regions rich in coal power such as Xinjiang and Inner Mongolia. It is well known that Chinese miners are rapidly searching for ways to transfer their operations abroad, or if they are unable to do so, sell their expertise to companies in other countries that may be interested. Cheap electricity and a cool climate are the most important factors, both of which Mongolia has in abundance. Additionally, Mongolia is right across the Chinese border which should enable an easy logistical transfer of mining related assets such as data center cooling infrastructure and computer mining hardware.

With the amount of distressed assets and plethora of Chinese expertise rapidly coming on to the market, we encourage the company to be aggressive in its pursuit of building out a cryptocurrency mining operation either through the acquisition of assets or via joint ventures with Chinese businesses looking to re-locate operations outside the country. As one of Mongolia’s few Hong Kong listed corporations, MMC is the best positioned amongst all Mongolian companies in terms of working with external partners due to the favorable rule of law and reporting / corporate governance provisions required by the securities authorities in Hong Kong. MMC has vast amounts of relevant expertise in managing large, asset intensive projects in Mongolia and we believe that with the appropriate Chinese expertise, MMC would be able to leverage its expertise in traditional natural resource mining to mining of cryptocurrencies. No other company in Mongolia is as well positioned.

As a first order of business, we recommend MMC rename itself to Mongolian CryptoMining Corporation. The financial press has detailed several examples whereby companies have incorporated variations of ‘Bitcoin’, ‘Blockchain’ or ‘Crypto’ into their names and have been awarded with immediate commensurate increases in stock price. Examples include Long Island Tea Corp’s renaming as Long Blockchain Corp or Riot’s renaming as Riot Blockchain. While such an action in and of itself is not sufficient and may not lead to any meaningful increase in MMC’s stock price, we feel that it provides the market with a strong signaling mechanism that MMC is actively taking means to diversify itself away from being a coal pure play subject to the whims of whoever sits in control of the Government of Mongolia.

We then encourage the company to explore not only the pursuit of cryptocurrency mining assets, but also other possible cryptocurrency avenues of business. We note that Mongolia’s current cryptocurrency exchanges are poorly supported, lack liquidity and are largely ineffective. By hiring Chinese expertise that is likely unemployed due to the closure of exchanges in China, MMC could fund the development of a robust cryptocurrency exchange that would allow the citizens of Mongolia to effectively trade between MNT and various crypto assets. MMC could fund an effort by either raising capital from what would be a position of strength via a higher stock price through a right offering to existing shareholders (to prevent dilution). Alternatively, MMC could also launch an ICO to the Mongolian people to fund the development of the exchange, similar to what Eastman Kodak announced recently with its own ICO photography effort. We believe that there is robust demand for cryptocurrencies in terms of serving as a store of value or an effective currency not subjective to bouts of inflation that have periodically plagued the MNT due to poor fiscal choices by Mongolia’s governments.

While we have been supportive of MMC’s management’s navigation of the complex situation in Mongolia over the past year, we refuse to allow MMC management to sit by idly and allow the equity to be impaired. We believe the time to act is immediately. If MMC management does not pursue such a desperately needed diversification, we believe that the Board has a fiduciary duty to replace management and conduct a search for a management team that will pursue a value creating strategy of diversifying into cryptocurrency related business.

We believe that cryptocurrencies and blockchain technology are rapidly gaining institutional acceptance all over the world. The directive by the Chinese government to reduce / stop cryptocurrency related activities creates an extremely compelling opportunity for not just MMC, but Mongolia itself. With MMC’s leadership, Mongolia could create a technological ecosystem rooted in cryptocurrency that would enable it to diversify away from its historical reliance on natural resource extraction. This would be good not only for existing MMC shareholders, but also for the Government and people of Mongolia.

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Disclosure: I am/we are long MOGLY, MOGLQ.

Additional disclosure: We are long the Hong Kong listed security and may buy or sell with respect to our position at any time without notice. Please see the disclaimer at the end of our post for further information.